Tuesday, July 08, 2014

An example of controlling risk

Following the US markets making new highs last week, together with the German DAX moving back over 10,000 and even the FTSE closing in on new highs, it seemed that the green light had been given to a new uptrend. However, as we know, there is no such thing as a can't fail trade or signal. And so it has proved. The markets so far this week have decided they do not want to move up at this stage.

The last ten days or so is a good example of how I control my risk. In this period, I have taken four new long trades, of which three have resulted in failed breakouts, with the resultant losses. However, because of my stop methodology, I only lost a cumulative -1.32R on those three trades. A couple of those trades were only open for a day or so. I have one remaining long position open, which currently has a profit of 1.39R, with its trailing stop close by. So, with only an effective win rate of 25% over those recent trades, I am very slightly up.

This can only be done if you are prepared to cut losses short – far shorter and quicker than most traditional trend following systems, where the losing trades are often allowed to generate a full 1R loss. I do not hope that those trades move back in my favour - I just want to keep those losses as small as possible and move on. This, combined with the scaling into positions and the aim of keeping our portfolio heat under control, aims to keep our equity as high as possible. This helps the overall compounding of returns and the limiting of any drawdowns.

It would have been very easy to pile into a whole bunch of trades last week with those new highs in the indices, but the danger with doing that is, if the market breakout fails, then you can suffer a number of quick losses. This is what we try to avoid.

As for my current plan of action, the number of potential setups on my long watchlist is reducing - they have been a sea of red so far this week. Therefore it's back to a case of being patient and disciplined, observing and waiting. To be clear, there is no change in trend as yet, even with my system at the shorter-term end of the trend following spectrum. so any bias would be to the long side until that changes.

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